August 7, 2008
Macroeconomists, like medical scientists, use case studies to teach their students about the maladies to which the system is susceptible. For supply shocks and stagflation, the example is the 1970s. The financial dislocations that occur when bubbles burst are illustrated by the Great Depression and Japan’s problems in the 1990s. The importance of central bank credibility in resisting inflation emerges from discussion of the experience of the late 1960s and the 1970s.
What is most remarkable and troubling about our current difficulties is that all these elements – supply shocks, financial dislocations and concern about rising underlying inflation – are present at once. Moreover, the crisis is global in scope. Concerns about recession are spreading from the US to much of the industrialised world. Significant slowdowns appear more likely in a number of emerging markets, with inflation concerns worldwide at their highest level in more than a decade. There is a growing consensus that the west is facing the most serious financial crisis since the second world war.
Perhaps unsurprisingly in the face of so many adverse surprises, the policy debate has become cacophonous. Some emphasise the necessity of the painful adjustments under way, while others urge their mitigation. Some focus on product price inflation, some on asset price deflation as the principal problem. Some focus on assuring that imprudent lending by financial institutions is discouraged, others on assuring that financing for investment by households and businesses remains available. Some focus on slowing market adjustments to prevent panic, others on the need for rapid adjustment of prices to true fundamental levels, even if this is painful in the short run.
Equally unsurprisingly given the chaotic debate, policymaking has become increasingly reactive and erratic, with a growing tendency to repeat traditional errors. While US policymakers have long cited Japan’s indecisiveness with respect to troubled financial institutions, its resort to gimmickry and market manipulation, and its lack of transparency in the management of financial crisis in the 1990s as a negative example, they are increasingly repeating Japan’s errors.
Within the past month, the Treasury has made explicit the implicit guarantee on the $5,000bn (£2,500bn, €3,250bn) balance sheet of Fannie Mae and Freddie Mac in order to prevent a run on the government-sponsored enterprises while imposing no penalties on shareholders or forcing any changes on management – not even the cessation of dividends.
The Securities and Exchange Commission has sought to make short-selling harder, with the stated objective of raising (many would say manipulating) the stock prices of financial institutions, while some in the Congress have proposed to prevent certain investors from going long on commodity futures. Without much sign of official resistance, the global banking industry is pushing for less reliance on market prices and more on managerial judgment in valuing the assets where bad credit and investment decisions have led to hundreds of billions of dollars of losses over the past year.
Setting policy in a more proactive and principled way requires reaching a number of judgments regarding where things currently stand and the likely effects of potential actions or failures to act. In an effort to advance the debate, the remainder of this article poses and provides my answer to what seem to me to be the crucial questions for American economic policy.
How long will the economy stay weak on the current policy path?
The best available estimates suggest that the American economy is operating between 2 and 2.5 per cent below its sustainable potential level. This translates into more than $300bn, or $4,000 for the average family of four, in lost output. Even if, as I think unlikely, recession is avoided, growth is almost certain to be so slow that the gap between actual and potential output comes close to doubling over the next year or so. Given that unemployment peaked nearly two years after the end of the last recession, output and employment are likely to remain below their potential levels for several years in the best of circumstances.
Given the combined impact of rising commodity prices, falling house prices, reduced availability of credit and rising uncertainty, it is surprising that the economy has shown as much strength as it has in recent months. While it is possible that this speaks in some way to its enormous resilience, the preponderant probability is that, as the effects of tax rebates wear off and those of tighter credit conditions feed through, the economy will take another downwards turn.
Just as the bottom was called early a number of times in Japan in the early 1990s and in the US in the early 1930s, we have seen and no doubt will see moments of sunlight that create hope that the worst is past. Yet it bears emphasis that in the current context there can be no confident reliance on the equilibrating powers of the market.
Alan Greenspan has been fond of explaining that the resilience of the American financial system and economy results from reliance on two pillars: banks and capital markets. When the banks were in trouble, as in 1991, capital markets took up the slack; when the capital markets were in trouble, as in 1998, the banks took up the slack. Unfortunately, today both the banks and the capital markets show signs of crisis.
The point can be put in another way. Four vicious cycles are simultaneously under way: falling asset prices are forcing levered holders to sell, driving prices further down; losses at financial institutions are reducing their ability to finance investment, which in turn reduces asset values, causing further losses; the weakness of the financial system is reducing growth, which in turn weakens the financial system; and falling output is hitting employment, which in turn leads to reduced demand for output.
Without active efforts to interfere with these mechanisms, there can be no basis for confidence that the American economy will recover even in the medium term.
Are substantial output losses necessary or desirable? or desirable?
It is often argued that the current economic downturn is an inevitability that cannot be prevented, or that is necessary and desirable. Some observers almost seem to suggest that a recession is a kind of just desert for a country that has lived beyond its means. The more serious concerns are that an economic downturn is a necessary concomitant of increasing US national saving and reducing current account deficits, or of preserving the credibility of the Federal Reserve’s commitment to price stability.
Granting that US consumer spending grew more rapidly than gross domestic product over most of the past decade and that ultimately the consumption share of GDP will have to fall back to more normal levels, it is hard to see why necessary increases in saving require a protracted recession. Instead, declines in consumer spending and improvements in the government’s fiscal position should be sequenced to coincide with improvements in net exports and investment. Allowing consumer spending to spiral downwards without offsetting policy actions risks reducing investment and incomes in the US and transmitting the US slowdown to the rest of the world. More-over, even if the argument for supporting consumption at present were rejected, there would still be a strong argument for supporting investment in areas such as infrastructure, where there is no evidence of a glut and considerable evidence of shortfalls.
As for the inflation question, constant vigilance is necessary. It is certainly true that product price inflation has ticked upwards, though this seems to be heavily commodity-related. Even if commodity prices do not fall but only stop rising, the result will be an improvement in standard inflation measures. Moreover, if the principal problem is commodity price inflation, there are surely better ways to address it than increasing unemployment and reducing capital utilisation.
Crucially for the inflation process, there is not yet evidence of rising wage pressures or increases in the growth rate of unit labour costs. Nor do indexed bond markets reveal a significant change in longer-term inflationary expectations. In an environment of rising unemployment, greater worker insecurity and constantly increasing global competition, there are likely to be substantial pressures militating against any rapid increase in wages in the big industrial economies. Without rapid increases in labour costs, which are by far the largest component of production costs, it is hard to see how higher rates of inflation can be entrenched.
On balance, in the US at least, the risk that output will be too low over the next several years seems considerably greater than the risk that it will be too great and cause the economy to overheat or overborrow.
Can policy stimulate demand without adverse side-effects?
With the Federal Funds rate at 2 per cent, the remaining scope for monetary policy to stimulate the US economy is surely very limited. Even here, those who see a case for raising rates should remember that in the current environment the Fed funds rate is a very misleading indicator, as widening credit spreads and increased term premiums have caused borrowing costs to fall much less than the policy interest rate.
There remains considerable scope, however, for fiscal policy to stimulate demand on both the tax and spending sides over the next several years. The limited available evidence suggests that the propensity to consume out of the recent round of rebates was larger than many suspected. More important, given the pressures on state and local budgets and the dramatic increase in some inputs (the cost of building highways has risen 70 per cent since 2004), there is now a substantial backlog of infrastructure construction projects that have been interrupted or put on hold. Allowing these projects to go forward on a significant scale would stimulate the economy and would channel demand towards the construction workers – mostly men with relatively little education – who have borne the brunt of the economic downturn and whose medium-term prospects are bleakest.
In thinking about fiscal policy, it is essential to consider both near and long term. For the near term, larger deficits are likely to be potent in stimulating demand, especially in the context of an economy where there are constraints on the ability to lend and borrow. This is especially the case when new spending is directed at addressing the “repressed deficit” associated with the failure to maintain an adequate infrastructure.
Success in using fiscal policy will depend on also taking concrete steps that reduce projected deficits in the medium to long term. The enactment of new permanent measures, such as the extension of the 2001 tax cuts, without means to pay for them would be counterproductive. Conversely, measures that pointed to long-term fiscal savings would reinforce fiscal stimulus.
In the current global context, there is no reason why fiscal stimulus should be confined to the US. Measures that increased spending in countries where high saving has led to large current account surpluses are necessary if the global economy is to be rebalanced without a big downturn as US saving eventually increases. China, where household consumption has fallen below 40 per cent of GDP – a record peacetime low for any big economy – stands out in this regard.
How serious are remaining financial problems?
This is unknowable given uncertainties about market fluctuations and the real economy. While there surely will come a time when things hit bottom, it is not yet clear that it is at hand.
Several sources of evidence suggest that house prices will fall for some time to come, perhaps by 10 per cent or more. Big further declines would be necessary to restore their traditional level relative to rents, incomes or the price of other goods. There are growing signs that rates of default and foreclosure will rise considerably even well outside the subprime sector.
Beyond housing, there are also grounds for considerable concern about consumer and automobile credit, particularly if the economy turns down. Big and as yet not reported losses on commercial construction lending lie ahead. While the rate of default on corporate debt has not yet reached high levels, this is likely to change in the near future. For example, the pricing of the debt of the big American automobile companies now suggests a probability well over 90 per cent that one or more of them will go into default in the next five years – and the probability would no doubt be greater if markets did not recognise the possibility of extraordinary Federal support.
Then there is the problematic situation of the banking system. Where traditional non-mark to market accounting is in use, banks have not yet revised estimates of their capital to reflect likely future losses. In many cases, they have instead assumed that the market’s valuation of their assets reflects transient liquidity factors rather than underlying problems, and so are planning with assumptions considerably more optimistic than those embodied in market prices. Perhaps they will prove correct – but nothing in the experience of the past year gives confidence in the judgment of those who believe that market prices substantially undervalue their assets.
In all likelihood, the financial system will require very substantial capital infusions over the next year or two if it is to remain healthy. It is not clear where the capital will come from. Most of those who have provided financial institutions with capital over the past year have been badly burned. As valuations fall, it becomes increasingly difficult for financial institutions to raise capital necessary for them to retain market confidence, leading to further declines in valuation and yet another vicious cycle.
How can the authorities best support the financial system?
To date the focus of public policy has been on the extension of credit to banks and other financial institutions by the Federal Reserve so as to ensure their liquidity. This strategy is appropriate but may be reaching its limits. Where the problems a financial institution faces are of confidence or liquidity, lending can be highly efficacious. When the problems are of underlying solvency and the constraint on lending is a lack of capital, lending is not an availing strategy. It is necessary, at least on a contingency basis, to plan policy responses to such problems.
First, as the ad-hoc nature of the policy response to Bear Stearns and the GSEs illustrates, we do not have a framework in place in which the authorities can do what is necessary to counter systemic risk when a systemically important institution gets in trouble and at the same time protect the interests of taxpayers and the broader financial system.
Second, there is as yet no framework in place for handling the large quantity of bad assets sitting on financial institution balance sheets. During the last US banking crisis in the early 1990s, the Resolution Trust Corporation was established to manage impaired assets of banks and savings and loan institutions that the government had taken over. But it acquired assets only after the government took over banks. Consideration should be given to whether the government should establish a mechanism for purchasing assets from stressed banks in return for warrants or other consideration.
Third, there is the question of whether the government will need to find a way to recapitalise institutions through taking some kind of preferred interest, as ultimately proved necessary in the US in the 1930s and Japan in the 1990s. This is obviously a big step that one wants to avoid if possible. But in the absence of any framework for the government infusing capital, there is the danger that liabilities will simply be guaranteed de facto or de jure with no other change made, creating serious problems down the road. Government involvement in recapitalising financial institutions is like devaluation. It is a very unattractive last resort. Delay is very tempting, but it can be enormously costly.
* * *
Today, the end of the current financial crisis looks further away than it did in August 2007. Policy has not yet gotten ahead of the curve. I used to remark in the context of the emerging market crises of the 1990s that I would date the moment of recovery from the first time an official pronouncement proved to be too pessimistic. By this standard, recovery is not at hand.
The best prospects for managing a very difficult situation involve a comprehensive effort both to support the real economy through temporary fiscal stimulus and the financial system through a programme of measures directed at capital rather than liquidity problems. These steps offer no assurance of success but reactive drift raises the risks of costly failure.
Copyright The Financial Times Limited 2012.